About $2 trillion is hidden in a Federal Reserve facility. Sooner or later this could be a problem for the banks.
The overnight reverse repurchase agreement, or reverse repo, allowed the Fed to mop up excess liquidity from the economy by giving banks or large fund managers a way to park cash and to get a return. Daily transactions in the facility hit $2 trillion last week and have remained around that level, up from around $1.5 trillion earlier this year.
From a stock market investor’s perspective, what may be most remarkable about this money is where it isn’t: in banks and money market funds. Bank deposits fell slightly between the week ended December 29 and mid-May, according to the latest figures from the Fed. And money market fund assets are down about 4% since the end of last year, according to figures from the Investment Company Institute.
According to the latest Fed minutes, one of the drivers of the increase in the use of reverse repo facilities has been a decline in the supply of Treasuries in the face of increased demand. One-month US Treasuries are now yielding around 0.75%, below the 0.8% repo facility rate. The expectation in the minutes is that reverse repo usage “could remain elevated in the coming months.”
For some of the larger banks, letting deposits go elsewhere may still be a necessary relief valve. Giant global US banks such as JPMorgan Chase have come under pressure on their capital ratios due to a flood of deposits on their balance sheets, which can lead to lower returns on equity or smaller share buybacks. So some deposits are essentially junk anyway, and banks don’t need to offer higher rates to keep them. Removing some non-essential deposits could help the bank “serve its customers in difficult times,” JPMorgan chief executive Jamie Dimon said Wednesday at a conference in Bernstein.
However, for banks that do not have a deposit funding surplus, or that have mostly “flying” institutional deposits that are very actively seeking the best rate, a flow of money away from banks could force them to compete faster for deposits than they could have anticipated.
Already in 2022, the bottom quartile of banks for deposit growth has lost an average of 10% of its commercial deposits from the fourth quarter to the first quarter, compared to a rise of 2% for the top quartile, according to Curinos, which provides data, technology and analytics to financial institutions. “The asymmetric impact between banks will accelerate the return to rate competition,” Curinos said in a recent note.
Even banks that don’t need to be competitive today may need it soon. Barclays strategist Joseph Abate estimates that there are around $1.5 trillion in excess “overload” deposits in US banks due to the pandemic. Given the expected pace of interest rate hikes and the reduction in the Federal Reserve’s portfolio, Abate expects money market flows to increase this summer and fiercer competition for deposits more late next year.
The degree of competition may also depend on what is happening in the economy. Analysts at Morgan Stanley Bank on Monday noted a decline in bank cash balances so far this year amid growing growth in loans and other demands. “The challenge is that [quantitative tightening] will accelerate this decline in bank liquidity,” they wrote. Without raising deposit rates or borrowing more from the capital markets, the banks’ alternative would be to slow loan growth. “Hold on, because the ride could get rough,” the analysts wrote.
Some of the repo money could eventually start flowing back into the banks as deposit rates rise, relieving some of the pressure, or the Fed could change the terms of the repo facility. . But the current direction of things could serve a key purpose. Bank of America rate strategists noted that banks may seek to offset rising deposit costs by raising lending rates for borrowers, and that the Fed may welcome these tighter lending terms “as they contribute to slowing the economy” and “would lean against inflation”.
This may sound like good news for inflation hawks. But bank investors are birds of a different feather.
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